The Problem with Too Much Cash

Cash is a unique investment: unlike stocks or bonds, you can use it to buy goods or pay your bills. And most cash-like investments (such as savings accounts at banks or money market funds) have very little risk since they promise to at least maintain the value of the investment. In some cases, such as with cash in US bank accounts below $250,000, this guarantee is explicitly backed by the US government.

The downside of cash is that because it is low-risk, it also tends to offer lower potential returns. After all, if other investments didn’t offer the possibility of better returns, everyone would simply keep their money in cash.

Therefore, for investors with longer time horizons, having a large allocation to cash can substantially reduce how much their portfolio is able to grow. According to data compiled by New York University professor Aswath Damodaran, $100 invested in 1928 in the S&P 500 index of large US stocks would have grown to over $250,000 by the end of 2013, compared with less than $2,000 for an investment in cash. The difference is even more dramatic after taking into account inflation, which would have eaten up two-thirds of the growth of the cash investment. And there wasn’t a single 20-year period during that span where cash outperformed the US stocks, let alone a more diversified portfolio of multiple asset classes.

That doesn’t mean investors should never hold any cash. If you have sizable near-term expenses, keeping a portion of your portfolio in a very low-risk investment such as cash can help ensure you’ll have enough money when the expenses come due. And if you’re worried that many other asset classes are going to perform poorly in the near future, temporarily increasing your allocation to cash is one way to reduce the amount of risk you’re taking. Maintaining a large allocation to cash for an extended period of time, however, it likely to limit the growth of your portfolio.